The Fiscal Cliff and Income Stocks

09/10/2012 7:00 am EST

Focus: DIVIDEND

Roger Conrad

Founder and Chief Editor, Capitalist Times

There's a great deal of consternation about what is going to happen if we hit the fiscal cliff and there's a ramp up in taxes on dividends. But don't let the rhetoric obscure the value of good income stocks, writes Roger Conrad of Investing Daily.

“The reason political party platforms are so long is that when you straddle anything it takes a while to explain it.”

That was what legendary entertainer Will Rogers quipped about political conventions and the policy platforms they produce. And while there weren’t too many surprises to emerge from the GOP’s latest platform, there were some planks that could have a substantial impact on investors—particularly if the party should win both ends of Pennsylvania Avenue in November.

Anything less than that, of course, would force both parties to compromise to pass any meaningful legislation. And it’s likely that frequent faceoffs over policymaking will continue anyway, particularly since any party that holds at least 40 seats in the Senate still has the ability to block almost any legislation by means of the filibuster.

Whoever wins the White House, however, will have enormous latitude when it comes to enforcing federal regulations under existing laws. And the list of affected industries includes everything from communications and electric power to natural gas drilling and media ownership.

One of the narratives in the Republican campaign this year is that the Obama administration has a hidden agenda that it’s waiting to spring on America in a second term. The president, however, not only enjoyed Congressional majorities in both houses during the first two years of his administration, but for several months his party actually had the necessary votes in the US Senate to invoke cloture and end filibusters. It’s a bit rich to claim there’s something he wasn’t pushing then when he held all the levers of power in Washington, and that he’s instead held it in reserve should he get elected to a second term.

Rather, the primary uncertainty surrounding this election is what will happen if Republican candidate Mitt Romney wins the White House. Romney’s claim that he would not reappoint Federal Reserve Chairman Ben Bernanke—who was originally appointed by Republican President George W. Bush—is certainly red meat for many conservatives.

But it does beg the question just who would he appoint to the position, and how much the decision would be influenced by politics. And there’s no doubt this will create uncertainty in global markets until the decision is made.

Similar uncertainty exists for other key offices the president appoints. For utility companies, a Romney win would bring a 3-2 Republican majority to the Federal Energy Regulatory Commission (FERC). The Obama FERC’s 3-2 Democratic majority has shown itself to be less laissez-faire than the Bush and Clinton FERCs that preceded it. My guess is that a Romney FERC would draw its cues from the Bush-era FERC, with consultation from the industry playing a bigger role.

The Republican Party platform, however, includes a sharp reversal from that of 2008, when it pledged support to nuclear energy as a way to reduce carbon dioxide emissions from power plants. Additionally, there’s opposition to tax credits to support renewable energy, and there’s only vague language about supporting oil and gas drilling in North America.

Most observers presume that a President Romney would support hydraulic fracturing or “fracking,” the drilling technique that’s absolutely essential for developing North American oil and gas. Romney has also released an energy plan that calls for, among other things, immediate approval of TransCanada’s (TRP) Keystone XL pipeline, the opening of whole new areas to offshore drilling off the US coast, and what would be largely an end to fuel-efficiency standards for vehicles.

How those plans would actually be enacted via policymaking, however, is far from clear. Companies could probably count on less scrutiny from the Environmental Protection Agency. Coal-fired power plants, however, still face a Bush-era rule on mercury emissions that’s slated to kick in starting in 2015.

That’s one reason why a change in the White House alone won’t guarantee a recovery for coal. The best the coal industry can hope for from a Romney win is more time to gear up its output for export, particularly to countries such as China that will build many more coal-fired plants than the US will close in the coming years. The likely change in policy will also give coal-burning utilities such as Southern Company (SO) a couple more years to transition to clean-burning natural gas.

Of course, most investors are far more concerned about how the outcome of the election will affect their tax rates. That was the clear message I got at the MoneyShow San Francisco last week, as well as from the MLP Profits subscriber chat my coeditor Elliott Gue and I held this week.

To review, if nothing else is done between now and January 2013, tax rates on income, dividends, and capital gains will revert to Clinton-era levels. That means dividends will be taxed at the same rate as ordinary income, which for some investors could be more than 40%.

Some suggest this will trigger a massive sell-off in dividend-paying stocks—as much as 25% to 30% below current values—as higher taxes will make them less attractive as investments.

As I’ve written previously, I view any lasting loss of dividend-stock valuations as highly unlikely. First, there was no surge in dividend-stock values following the enactment of lower dividend tax rates back in 2003. Second, the majority of the float of dividend stocks is owned by institutions, which aren’t affected by changing tax rates. And much of the rest is held inside IRAs and other tax-deferred retirement accounts.

Finally, even if dividends are fully taxed at the highest rate, dividend stocks are still the only game in town to generate the necessary income for retirement, as bond yields are at multi-decade lows and “savings” yields are almost nonexistent. Regardless of whether there will be higher tax rates, there are simply no alternatives.

If there is a sell-off due to higher tax rates, the resulting higher yields and more attractive valuations will soon lure new buyers, which will quickly erase any losses. Fortunately, the most likely outcome no matter who wins the election will be a compromise that will prevent the dreaded “fiscal cliff” in 2013.

Europe’s economic turmoil is a continuing reminder of how aggressive austerity measures do more harm than good, as sharply reduced government spending sends economies reeling by crimping government revenue and running deficits ever higher.

No one ever went broke betting on the venality and ignorance of politicians. But given that example—despite the tough talk leading up to the election—it’s in everyone’s best interest to forge a deal that avoids what could certainly be an economic catastrophe. The only question is what that compromise will look like, and that ultimately depends upon which party holds more power after the election.

So the most likely outcome following November is a post-election compromise with some tax benefits and spending restored and no fiscal cliff.

But I also strongly believe in the Boy Scout motto: Be prepared. That means making sure the underlying businesses of your portfolio holdings can endure the possibility of a sharp slowdown in US economic growth.

The need for minimal debt refinancing between now and the end of 2013 is one sign of strength for companies. Also, companies that proved their ability to continue producing revenue and paying dividends during the 2008-2009 Great Recession are likely to fare well in a worst-case scenario for 2013.

Finally, make sure you own some dividend-paying stocks that will remain tax-advantaged. That means master limited partnerships (MLPs), particularly those in the energy midstream business.

MLPs pay dividends that are part return of capital and are therefore not taxed until you sell, and only then as a capital gain. And energy midstream is one business that held up well in 2008-2009, thanks to reliance on long-term contracts and the minimal impact of energy price swings.

MLPs were not part of the agreement last year that raised the ceiling on US debt in exchange for automatic spending cuts and tax increases that comprise the so-called fiscal cliff. Their tax status could be threatened at some point in the future. But they won’t be if there is a fiscal cliff. In fact, their tax advantages will only make them more valuable.

One good example: Spectra Energy Partners (SEP). The company’s major assets are pipelines and related facilities that provide natural gas to power utilities, which are increasingly switching over to cheap gas. And it’s backed by Spectra Energy (SE), a major player in the energy business and a source of asset “dropdowns” to the LP.

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